Alcoa 2009 Annual Report Download - page 145

The following table shows the net fair values of outstanding derivative contracts at December 31, 2009 and the effect
on these amounts of a hypothetical change (increase or decrease of 10%) in the market prices or rates that existed at
December 31, 2009:
Fair value
asset/(liability)
Index change
of + / - 10%
Aluminum contracts $(804) $227
Interest rate contracts 48 14
Energy contracts (24) 43
Foreign exchange contracts 7 4
Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly
transaction between market participants at the measurement date. The fair value hierarchy distinguishes between
(1) market participant assumptions developed based on market data obtained from independent sources (observable
inputs) and (2) an entity’s own assumptions about market participant assumptions developed based on the best
information available in the circumstances (unobservable inputs). The fair value hierarchy consists of three broad
levels, which gives the highest priority to unadjusted quoted prices in active markets for identical assets or liabilities
(Level 1) and the lowest priority to unobservable inputs (Level 3). The three levels of the fair value hierarchy are
described below:
• Level 1—Unadjusted quoted prices in active markets that are accessible at the measurement date for
identical, unrestricted assets or liabilities.
• Level 2—Inputs other than quoted prices included within Level 1 that are observable for the asset or liability,
either directly or indirectly, including quoted prices for similar assets or liabilities in active markets; quoted
prices for identical or similar assets or liabilities in markets that are not active; inputs other than quoted
prices that are observable for the asset or liability (e.g., interest rates); and inputs that are derived principally
from or corroborated by observable market data by correlation or other means.
• Level 3—Inputs that are both significant to the fair value measurement and unobservable.
The following section describes the valuation methodologies used by Alcoa to measure derivative contracts at fair
value, including an indication of the level in the fair value hierarchy in which each instrument is generally classified.
Where appropriate, the description includes details of the valuation models, the key inputs to those models, and any
significant assumptions.
Derivative contracts are valued using quoted market prices and significant other observable and unobservable inputs.
Such financial instruments consist of aluminum, energy, interest rate, and foreign exchange contracts. The fair values
for the majority of these derivative contracts are based upon current quoted market prices. These financial instruments
are typically exchange-traded and are generally classified within Level 1 or Level 2 of the fair value hierarchy
depending on whether the exchange is deemed to be an active market or not.
For certain derivative contracts whose fair values are based upon trades in liquid markets, such as aluminum options
and interest rate swaps, valuation model inputs can generally be verified and valuation techniques do not involve
significant management judgment. The fair values of such financial instruments are generally classified within Level 2
of the fair value hierarchy.
Alcoa has other derivative contracts that do not have observable market quotes. For these financial instruments,
management uses significant other observable inputs (e.g., information concerning time premiums and volatilities for
certain option type embedded derivatives and regional premiums for swaps). For periods beyond the term of quoted
market prices for aluminum, Alcoa uses a macroeconomic model that estimates the long-term price of aluminum based
on anticipated changes in worldwide supply and demand. Where appropriate, valuations are adjusted for various factors
such as liquidity, bid/offer spreads, and credit considerations. Such adjustments are generally based on available
market evidence (Level 2). In the absence of such evidence, management’s best estimate is used (Level 3).
137